These are usually niche businesses that have great potential. Since their market capitalization is low, they carry more risk but can also offer higher returns.
Every investor can add small cap stocks to their portfolio. However, like any other type of investment, there are pros and cons to invest in small cap stocks.
Here are some of the benefits.
Small cap stocks, by definition, have more growth opportunities than their larger counterparts. The logic behind this is simple.
It is easier and faster for a small business to double in size than a large one. So while a Sheela Foam can easily double its sales and profits within two years, a Hindustan Unilever will struggle to do the same.
This can also be seen in the performance of the small cap index.
It’s no surprise that the S&P BSE Small Cap Index has outperformed the S&P BSE over the past 10 years.
Even when you look at individual stocks, 36% of stocks in the mid cap index today were in the small cap index 10 years ago. This shows that the scope for growth in a small cap is enormous.
Access to niche businesses
Small cap stocks are a gateway to investing in niche growth stories.
Take Oriental Carbon & Chemicals for example. It is the only company in India to manufacture a specialty chemical, insoluble sulfur (used to vulcanize rubber for tire manufacturing) and is a market leader in the segment with a 60% share.
Even Sheela Foam, India’s leading mattress company that owns the Sleepwell mattress brand, is a prime example. It is a market leader, with almost 30% market share of organized mattresses. This stock has been an investor favorite, having seen phenomenal growth over the past few years.
But is now the right time to invest in small cap stocks?
A good way to judge this is to look at the ratio of the small cap index to the Sensex.
The long-term median of this ratio is 0.43 with the previous peak at 0.58.
Right now, the ratio is 0.5, indicating that there is some room for further gains.
However, since it is above the long-term median of 0.43, small cap stocks are not available at a steep discount from the past.
Small cap stocks seem like a surefire route to better returns. So who wouldn’t want that. But why don’t people just invest in small cap stocks?
Here are some of the disadvantages.
Volatility is the rate at which the price of a stock increases or decreases over a period of time. This volatility increases as you move down the market capitalization scale.
This is where your small caps are. Sure, they offer better returns than large caps, but they also come with higher volatility.
Since they are priced lower than largecaps or midcaps, they fluctuate much more than their safer counterparts as markets move.
You will notice that small caps outperform in bull markets but fall faster during bear markets.
This is because small businesses lack the financial strength to withstand downturns.
This risk of losses, coupled with more volatile returns, drives investors away from small-cap stocks.
Primarily suitable for long-term investors
Small caps are long term games, requiring you to be patient.
This means that you should only invest if you have excess funds. Funds you won’t need for at least 7-10 years.
For investors nearing retirement, they might not be a suitable investment.
Another risk factor when it comes to small caps is the low level of liquidity. Located at the lower end of the market cap spectrum, small cap stocks are less liquid than their large cap counterparts.
This low level of liquidity can make these stocks potentially unavailable. It may also be difficult for investors to sell the shares at a favorable price.
What should investors do?
Build a solid small cap investment strategy.
A simple way to circumvent most risks is to develop a solid investment strategy.
This involves building a portfolio that reflects your financial goals, helping you weather any major market fluctuations.
Let’s understand this better with an example.
Let’s say you plan to invest in your child’s education 15 years from now.
As your time horizon is longer, you can absorb more risk, i.e. resist market fluctuations. Thus, you can invest in “riskier assets” such as small caps and aim for higher returns.
Imagine that you have invested over the past year. Every time the markets fell, the small and mid caps crashed along with the large caps. But, if your investment horizon was longer, the drop wouldn’t have bothered you. You could keep calm because you didn’t need that money any time soon.
Allocate capital wisely
If your portfolio always reflects your financial goals, you can withstand any market movement. You can accept the volatility, knowing that there are other asset classes that will provide returns when equities are affected by a downturn.
Note that in an ideal fund allocation scenario, small cap stocks should not represent more than 10% of the total equity portfolio.
Additionally, a single small cap stock should ideally represent no more than 2-3% of the total portfolio. This allowance will vary from person to person.
Conduct in-depth research
Another way to lower your risk level is to do some research. Avoid companies whose business you don’t understand. Study the current activity and its prospects.
After all, the price you pay today is a function of the company’s future revenues and assets.
You can start by using these filters to narrow your search to quality companies for the next stage of analysis.
● A healthy balance sheet – Low leverage, ie low debt ratio and high interest coverage ratio is preferable.
● Strong cash flow – Check how long operating cash flow has been positive. The longer the history, the better. ● Consistent earnings growth – Steady revenue growth is always a good sign. Not only does this imply that the business is well established, but it is also a sign of competent management.
● High return on equity – Companies in the non-financial sector must achieve an ROE of 15% or more. Financial companies must generate an ROE above 15%.
● A competent management – Prefer companies whose management has a clear intention towards the shareholder.
● Bright business prospects – Market leaders in their fields can be excellent investments. The company must boast of an excellent product or service.
● Attractive valuations – Buy stocks with a margin of safety. If your expectations don’t come true, you have a cushion to absorb the shock.
Every investment carries a potential return and risk. The key to successfully investing in any type of business, big or small, is to minimize your risk.
Focus on developing a solid investment strategy. If you don’t have one, start working on it. If so, check to see if your investments are on track and continue to reflect your time horizon, financial situation and risk tolerance.
If you strive to build a well-diversified portfolio of fundamentally sound companies with great potential, you will succeed.
This article is syndicated from equitymaster.com
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